This is ultimately about the euro and the EU. Today’s post is about creating a framework for thinking about this issue.
It’s a condensed version of a longer post I wrote six years ago on Balance of Payments (actually, a series, for anyone who’s interested). Although a big simplification of what is actually going on in the world, it highlights what I believe is a central structural issue facing the EU and Japan today …and potentially the US, at some point.
imports and exports
The residents of any given country typically don’t consume only items made in that country. They buy imported goods as well. In fact, the marginal propensity to consume imports is normally higher than the marginal propensity to consume, meaning that as spending increases imports rise at a faster rate.
paying for imports
The country as a whole gets the money to pay for imports in one of a number of ways: it can make things to sell to foreigners, it can use accumulated savings, it can sell assets to foreigners or it can borrow.
In an ideal world, every country would make and sell exactly enough goods and services through export to pay for the imports it purchases. That’s seldom the case, however.
Consider a country that, year after year, buys more from foreigners than it can pay for with the proceeds from what it sells. To continue consuming foreign goods at the same rate, such a country has to either sell assets, like land or companies, or borrow from foreigners. At some point, however, it will reach the limits either of what it has that others want to buy or the amount foreigners will lend.
This situation sets the stage for a potential foreign currency/trade/economic growth crisis.
Here’s where we get to internal/external adjustment.
There are two ways of dealing with this issue:
–the government can slow down overall consumption (essentially, create a recession) by raising interest rates/taxes by enough to decrease consumption of foreign goods and services
–domestic industries can voluntarily restructure themselves, with/without government help, to improve quality and lower prices so they make more things foreigners will want (unlikely to happen on a large scale)
–the government can erect tariff or regulatory barriers to imports, to try to redirect consumption to domestic goods (almost always a bad idea: look at the US auto industry since the mid-Seventies)
None of these actions are likely to win unanimous applause from voters. And if legislative action produces negative results, it will be completely clear who is to blame. So politicians everywhere, and particularly in badly-run countries, tend to not to want to choose any one of them. Instead, they most often opt for the external adjustment route.
–This means to encourage or embrace a decline in the local currency versus that of trading partners. That simultaneously makes foreign goods more expensive for locals and local goods cheaper for foreigners. Devaluation will encourage exports and inhibit imports, achieving the same end as rising interest rates, but without the sticky legislative fingerprints attached. It’s those horrible foreign exchange markets instead.